What are the contagion effects of a China slowdown?

Periodically, the market is rattled by a “China is slowing” narrative. As the accuracy of official Chinese statistics can be doubtful, the real-time market reaction indicates nervousness, but no panic. The performance of the equity markets of China and her major trading partners relative to MSCI All-Country World Index (ACWI) shows that their trends are all flat to down.



How concerned should investors be about a China slowdown and its contagion effects?


Assessing the damage

The economic news out of China is certainly concerning. Bloomberg columnist John Authers pointed out that the six-month average of Chinese growth rates in different categories have been significantly decelerating.


The bad news just keeps on coming. Large Chinese shadow bank Zhongzhi and its affiliate Zhongrong missed payments on several investment products as a result of China’s property slump. The move sparked rare protests in Beijing.


The PBOC unexpectedly announced a cut in the medium-term lending rate by 15 basis points, which unsettled markets. What does the PBOC know that the rest of us don’t?
The offshore yuan, or USDCNH rate, has been weakening and briefly breached the 7.35 level. The yuan exchange rate was not helped by the ultra-dovish policies of the BoJ, which weakened the Japanese Yen and created competitive devaluation pressures in Asia.



Not as bad as it sounds

It may not be as bad as it sounds. In a recent podcast, Leland Miller of China Beige Book, which monitors the Chinese economy from a bottom-up basis, argued that the market has over-reacted to the prospect of the Chinese slowdown. There are two elements of the China slowdown story, a cyclical and a structural element. Miller believes that Chinese cyclical growth is better than the market believes, though he allowed that the structural elements are creating long-term headwinds.


Consider, as an example, Fathom Consulting’s China Momentum Indicator, which tracks Chinese GDP in a noisy fashion. The bad news is that China is indeed slowing. The good news is growth momentum is exhibiting a series of higher lows.


Beijing’s announcement that it would stop reporting the youth unemployment rate, which is at about 20% and a record high, illustrates the long-term structural challenges facing the Chinese economy. This NY Times article about China’s skyrocketing youth unemployment provides some context. Young educated graduates simply can’t find jobs, which has led to the “lying flat” movement, or the refusal to pursue a career, or consider leaving the country. In response, Xi Jinping advised the young to “eat bitterness” or to learn to endure hardships.


The youth unemployment problem seems curious in light of China’s aging demographics. Birth rates have been dropping and recently fell below the death rate. Why can’t the young find employment in an economy with aging population, which should give rise to strong employment demand?



The answer is a skills mismatch. There are plenty of low-paying jobs, but a lessened demand for the skilled workers that the Chinese education system is churning out. The NY Times article reported that “a 11.6 million college graduates are entering the work force this year, and one in five young people is unemployed”. The skills mismatch and youth unemployment problem illustrates China’s long-term challenge of transforming its economy from relying on low-cost labour as a source of competitive advantage to higher value-added production, which requires more skilled and educated workers.

In the long run, China faces a competitive imperative to migrate up the value chain. Chinese wage rates are already being undercut by its Asian neighbours such as Vietnam and it’s losing its edge in cheap labour costs. As well, the Party has tried to assert greater control over businesses, which as scared away foreign investment. As a consequence of these factors, Foreign Direct Investment has collapsed.




The market reaction

The market fallout from China slowdown fears has been limited. The primary tool for my analysis is the Relative Rotation Graph, or RRG chart, which is a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotate to lagging groups (bottom left), which change to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.